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The two tailed banking crisis

From the first quarter of 2008 to the first quarter of 2009, quarterly noninterest revenue for corporate- and investment-banking activities increased by a surprisingly large $26.3 billion. Total credit losses on US-originated debt from mid-2007 through the end of 2010 will probably be in the range of $2.5 trillion to $3 trillion, given the severity of the current recession. Since the middle of 2007, the US banking and securities industry has absorbed some $490 billion in losses. Since 2006, net interest margins have actually increased for the stress-tested banks.

The good news is that we appear to be seeing the end of this credit securities crisis. That is in part due to the clarity provided by the stress test exercise [I disagree here, there was no clarity provided, just a simulacrum of security which has manifested itself in a dangerous complacency. The fact of the matter is that the tests were unrealistic in the optimism of their worst case assumptions, many of which have already been pierced, and they simply took a static snapshot of a dynamically morphing, fluidic situation! See:

and the ongoing commitment on the part of government not to allow a large-scale bank failure [this part I do agree with]. The other credit crisis is a commercial-bank lending crisis [I have been pounding the pavement on this one for quite some time]. While this crisis also stemmed from bad residential mortgages, it involves a broader array of lending, including commercial real-estate loans, credit card loans, auto loans, and leveraged/high-yield loans, all of which are now going bad because of the economic downturn. The bulk of these loans are subject to hold-to-maturity accounting, which, in contrast to fair-market accounting, typically does not recognize losses until the loans default. The bad news is that this crisis is still in its early stages and may take two years or more to work through the credit losses from these loans.

Of course, all large financial institutions hold both kinds of credit assets on their books. Some of the largest broker-dealers hold 70 percent of their assets at fair value, while some regional banks hold up to 90 percent of their assets in hold-to-maturity accounts. For the banking and securities industry as a whole, about two-thirds of assets are subject to hold-to-maturity accounting.

It might seem odd that accounting methodologies can make such a big difference. At the end of the day, what counts is the net present value of the cash flows from each asset, but those are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the assets declines. Fair-value therefore makes the holder of the assets look worse, sooner. Hold-to-maturity accounting works in reverse and makes the holder look better for a longer time. [Keep this thought in mind when analyzing what's left of the Doo-Doo 32 and the most recent retail bank analysis subject, which was simply busted in the act of blatant accounting shenanigans, see Tricky Dick Bank Reporting Schemes - What record earnings are you referring to?]

The authors then go on to state that Q1 bank profits have justifiably increased. I am reticent to accept those increases as the good news that most others do. For one, they were concentrated in highly volatile areas of trading and arbitrage